Successfully raising dividends is something that not every company is positioned to do. Annual increases mean that a company’s business model must be strong enough to grow distributions even in times of economic hardship.
Navigating recessions or avoiding company-specific challenges is hard to do, which is why there are less than 40 Dividend Kings, which are those companies with at least 50 years of dividend growth, and fewer than 70 Dividend Aristocrats, which are those companies with at least 25 years of dividend growth. Yet surprisingly, there is a highly cyclical stock that has one of the safest dividends in the market - Caterpillar Inc. (CAT, Financial).
Company background and earnings
Caterpillar has been is business for nearly 100 years. The company is a leading provider of construction and mining equipment and supplies industrial gas turbines as well as diesel and natural gas engines to customers around the world. Caterpillar is valued at $109 billion.
The company reported fourth-quarter and full year earnings results for 2021 on Jan. 28. For the quarter, revenue grew nearly 23% to $13.8 billion, while adjusted earnings per share of $2.69 compared positively to adjusted earnings per share of $2.12 in the prior-year quarter.
For the year, revenue increased 22% to $51 billion. Adjusted earnings per share were up significantly to $10.81 from $6.56.
Results for the both the quarter and year were driven by higher demand due to the ongoing economic stimulus measures that were implemented due to the Covid-19 pandemic.
Looking back further, revenue and adjusted earnings per share have a five-year compound annual growth rate (CAGR) of 2.9% and 12%, respectively. The divergence of the two growth rates is due to an improvement in profit margin of 260 basis points as well as a reduction in the share count.
Going back to 2012, revenue has actually declined over the last decade at 2.8% per year. Adjusted earnings per share has a CAGR of just 1.6% thanks again to a 210-basis point improvement in the profit margin and a lower share count.
Dividend history and recession performance
Despite operating in a highly cyclical industry, Caterpillar has a very long history of dividend growth. Including a 7.8% increase announced last June, the company’s dividend growth streak is 28 years in length. This qualifies Caterpillar as a Dividend Aristocrat.
Caterpillar’s dividend growth streak covers several periods of economic uncertainty, which includes the Great Recession. Below are the company’s adjusted earnings per share results before, during and after the last recession:
- 2006 adjusted earnings per share: $5.25
- 2007 adjusted earnings per share: $5.32 (1.3% increase)
- 2008 adjusted earnings per share: $5.71 (7.3% increase)
- 2009 adjusted earnings per share: $1.43 (75% decrease)
- 2010 adjusted earnings per share: $4.15 (190% increase)
- 2011 adjusted earnings per share: $7.81 (88% increase)
- 2012 adjusted earnings per share: $9.36 (20% increase)
At first, Caterpillar withstood the impact of the financial crisis, but the company suffered a significant decrease in earnings in 2009. However, the company quickly rebounded to growth the following year and then made a new high for adjusted earnings per share by 2011.
While the business was weakened during this period of time, the company continued to increase its dividend. In fact, dividends per share grew close to 22% for the 2007 to 2009 time period.
More recently, Covid-19 was (very briefly) a headwind to Caterpillar’s business. In 2020, revenue decreased 22% while adjusted earnings per share was 45% lower than the prior year. These were the steepest declines since the Great Recession for the company.
Caterpillar did maintain its dividend in 2020 despite the pandemic. The quarterly payment remained unchanged for eight consecutive quarters. Due to the timing of the increase in 2019, the dividend still grew year-over-year.
Shares currently yield 2.2%, which is below the 10-year average of 3%, but ahead of the 1.4% average yield of the S&P 500 Index.
Dividend growth and payout ratios
Over the last five years, the dividend has compounded at a rate above 8% annually. Going back to 2012, that growth rate expands to nearly 9% per year.
Even with tepid top- and bottom-line growth over the last decade, Caterpillar’s dividend has still improved at a high rate. This is possible because Caterpillar has reasonable earnings and free cash flow payout ratios.
For example, Caterpillar distributed $4.28 of dividends per share last year. Using adjusted earnings per share for the period, the payout ratio was just 40%. Even with uneven earnings growth over the the long-term, the company has generally had a very healthy payout ratio. The five- and 10-year average payout ratios are 42% and 47%, respectively, meaning that Caterpillar’s payout ratio in 2021 was actualy lower than its average.
Caterpillar has done a very good job of maintaining a conservative payout ratio as the earnings payout ratio has exceeded 45% for the year just three times in the last decade (2020, 2016 and 2015). It should also be noted that the average dividend payout ratio for the 2007 to 2009 time period was just 38%. Even a drastic decline in earnings didn’t impact the payout ratio all that much.
Free cash flow paints a similar picture of dividend safety. Caterpillar’s dividend payments to shareholders totaled $2.33 billion in 2021. The company generated free cash flow of $4.73 billion for the year, resulting in a free cash flow payout ratio of 49%. This is lower than the three-year average free cash flow payout ratio of 52%.
Using either earnings or free cash flow, Caterpillar’s dividend looks to be secure.
The impact of debt on dividend security
Aside from payout ratios, debt can also determine a company’s ability to raise its dividend. Especially with cyclical companies, debt can become a huge drag on everything during periods of economic distress.
Caterpillar’s interest expense was $488 million in 2021. With total debt of $37.8 billion, the company has a weighted average interest rate of 1.3%. The chart below shows how high the blended interest rate would have to increase before dividends would no longer be covered by free cash flow.
Source: Author’s calculations
Looking at the chart, we see that the weighted average interest would need to be above 7.8% before dividend payments could no longer be covered by free cash flow. While investors should always be mindful of the amount of debt on a company’s balance sheet, Caterpillar’s obligations do not appear to be a headwind in its ability to continue to make dividend payments.
Final thoughts
Growing dividends over long periods of time is not easy, or else there would be far more companies in the Dividend Kings and Dividend Aristocrats lists.
Caterpillar qualifies as a member of the latter due to its strong business model and ability to recover from sharp declines even in economic downturns. Dividend growth continued through the last recession, and the dividend was not decreased due to the pandemic. The company can raise its dividend through recessions because its payout ratios are on the low side and cash flows are strong. Debt is unlikely to impact the company’s ability to raise its dividend as well.
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